Credit-rating agencies

Three is no crowd

Regulators need a new approach to an entrenched industry

IT IS unjust to compare the plight of General Motors (GM), America's largest carmaker, to that of Enron, the energy giant brought down by fraud. And yet for big credit-rating agencies, it could be argued that both represent a sort of failure. The agencies rated Enron's bonds as investment-grade—safe for many pension funds, that is—until shortly before the firm collapsed. They also failed to flag problems at WorldCom and Parmalat before they went bankrupt. Now the agencies face questions about slow action on GM. The market reduced its bonds to junk status (albeit because of poor profits, not fraud), below the level at which the agencies had assessed them, even before GM's profit warning last week.

Regulators and investors around the world will closely watch the dance between GM and the raters. Moody's, Standard & Poor's (S&P) and their growing rival, Fitch, are among the most powerful voices in today's capital markets (see article). Moody's alone assesses the likelihood of default on $35 trillion of debt. Mostly the raters' record is good, but on occasion they are quite wrong. Despite the agencies' defence that they cannot spot fraud, regulators are scrutinising them anew in light of the Enron and WorldCom failures.

There is plenty to be concerned about. The big agencies' business model has a built-in conflict of interest. Ratings are paid for by the issuers of bonds and other forms of tradable debt, not by investors who use them. Can they be completely independent of the firms who pay the bills? The agencies insist they can. Internal firewalls bar analysts from fee discussions, they say, and each issuer accounts for a tiny proportion of their revenues. Their businesses stand or fall on their reputation for independence, and they would never risk that.

This is all true. And yet there are unsettling parallels to the disgraced auditing industry, which made the same arguments. The rating agencies are starting up consulting businesses which advise on matters that might affect an issuer's rating. Auditors were forced to spin off consulting arms a few years ago. Also like auditors, credit-rating agencies in effect constitute an oligopoly. The big three are globally dominant and able to charge hefty fees. Issuers can do little but grouse quietly, because they need the ratings in order to issue bonds.

What should regulators do about this? Officials have few statutory powers over credit-rating agencies. They can take action against fraud but have no ability to monitor ordinary activities, as they do with banks or mutual funds. No one wants heavy regulation. The world's securities regulators last year put forward a voluntary code of conduct, and European regulators are expected soon to endorse such self-policing as well. America could go further. The Securities and Exchange Commission (SEC) wants lawmakers to give it the authority for monitoring the agencies if questions arise. Congress should agree to this. If it does, the SEC should scrutinise the agencies' consulting operations, and perhaps seek to ban them.

Open the doors

But even without increased authority from Congress, the SEC could take an easier step. Ironically, the sole power it now has over raters is to reinforce their oligopoly. Thirty years ago the SEC started designating certain firms as “Nationally Recognised Statistical Rating Organisations” (NRSROs). Many laws and regulations refer to NRSROs, and some pension funds and mutual funds limit their purchases to bonds rated investment-grade by agencies with that designation. This makes it especially hard for newcomers to break into the ratings business.

The SEC sees the problem. In the past two years it has recognised two more agencies, bringing the grand total of NRSROs to five. The SEC also wants to define its ungainly acronym for the first time. That is useful; but why not abolish it altogether? More competition would not result immediately. Entering the rating business will remain difficult for any newcomer because of the need to build a reputation among issuers and investors. Still, doing away with this artificial designation would cause a rethink of old investment prospectuses and regulations, which lock in the importance of a privileged few. New agencies could rise in specialist fields. That might make the big three strive even harder to maintain their own reputations.